Cryptocurrency has become a commonplace in modern investing. But when it comes time to file your taxes, things get murky, especially if you’re new to the world of crypto. Are your profits considered capital gains, or are they taxed as ordinary income? The answer is not always simple. As a company specializing in deferred sales trusts, let us explain.
The IRS Says Cryptocurrency Is Property, Not Currency
The IRS treats cryptocurrency, a digital asset, as property, not currency. This means that
every time you dispose of it, whether by selling, trading, or even using it to buy a cup of coffee, you trigger a taxable event. But whether that event counts as capital gains or ordinary income depends on how you acquired the crypto and what you did with it.
When Crypto Is Treated as Capital Gains
If you bought crypto as an investment, held it, and later sold or exchanged it at a profit, that gain is typically treated as a capital gain.
Similar to stocks or real estate, you’ll owe taxes based on the holding period:
- If you held the asset for more than a year, it qualifies as long-term capital gains (which usually means lower tax rates).
- If you held it for a year or less, it’s a short-term capital gain, which is taxed at your ordinary income rate.
Say you bought Bitcoin for $20,000 and sold it six months later for $30,000. That $10,000 profit is a short-term capital gain and taxed similarly to regular income. However, if you held it for 18 months before selling, it qualifies for long-term capital gains rates, which may save you thousands in taxes.
When Crypto Is Treated as Ordinary Income
- Mining Rewards: If you mined cryptocurrency, the coins’ fair market is your income and taxed as such.
- Airdrops: Received a crypto airdrop? The value of the tokens when they hit your wallet counts as income, even if you didn’t ask for them.
- Staking Rewards: If you earn rewards from staking crypto, those rewards are also considered income, not capital gains.
- Compensation: If someone paid you in Bitcoin, that’s income, not an investment.
In all of these situations, you report the fair market value of the cryptocurrency when you receive it. And yes, that’s taxable even if you never cashed out. If you sell that cryptocurrency later at a higher or lower price, you’ll also report a capital gain or loss on that second transaction.
So, income first, capital gains second.
Why the Classification Matters
Tax rates on ordinary income are the same as your marginal income tax rate, which could be as high as 37%1 federally, plus any applicable state income taxes. Meanwhile, long-term capital gains are taxed at preferential rates—0%, 15%, or 20%, depending on your income level.2
This means the classification of your crypto earnings can dramatically affect your bottom line.
Here’s an example:
Suppose you earned $50,000 worth of Bitcoin through staking. That’s taxed as ordinary income. If your marginal tax rate is 32%, you could owe $16,000 in taxes.
Now contrast that with selling long-term crypto investments. If you had a $50,000 gain from holding Bitcoin over a year, you might owe just $7,500 in taxes at a 15% capital gains rate. That’s an $8,500 difference.
How to Keep Your Tax Strategy Clean
Since cryptocurrency straddles the line between investment and income, you need a well-documented strategy to stay compliant and minimize your tax burden. That starts with keeping meticulous records.
Track:
- Purchase and sale dates
- Cost basis and fair market value
- How you acquired the crypto (purchase, gift, mining, staking, etc.)
- Any income received in crypto form
You’ll need this information to properly report cryptocurrency activity on Form 8949, Schedule D, and Schedule 1 or C, depending on how you earned the income.
While you can’t avoid capital gains tax on cryptocurrency, it’s wise to consult with a tax advisor experienced in digital assets. They’ll help ensure that you’re not only compliant but also taking advantage of every legitimate opportunity to reduce your tax bill.
Can a Deferred Sales Trust Be Used for Cryptocurrency?
Are you sitting on a significant crypto gain and want to exit without triggering a massive tax bill? Then a Deferred Sales Trust (DST) might be in order.
Say you’ve accumulated a high six- or seven-figure crypto position and want to convert that into stocks, bonds, or more diversified assets. If you sell outright, you’ll owe a hefty capital gains tax bill.
But if you use a DST, you can sell your crypto to a trust, defer the capital gains tax, and reinvest the proceeds through the trust. This keeps more capital working for you while limiting your tax exposure.
A DST is a powerful tool. However, you need to execute it carefully with legal and financial professionals. Not every situation qualifies for a DST, and structuring the transaction correctly is key to IRS compliance.
Don’t Guess on Crypto Taxation
The IRS closely monitors cryptocurrency activity, so you can’t afford to get this wrong. Misclassifying income versus capital gains can lead to penalties and severe headaches down the road. But the right capital gains tax planning, you can stay ahead of the curve and optimize your outcomes.
Whether you’re actively trading or sitting on long-term gains, know where you stand. Then use that insight to create a tax strategy that protects your profits and helps your wealth continue to grow.
1https://www.irs.gov/filing/federal-income-tax-rates-and-brackets
2https://www.irs.gov/taxtopics/tc409